Think You're Globally Diversified? Think Again.

One of the most repeated buzz words across the investment world is arguably "diversification," especially as it relates to international exposure.

There's no doubt that diversification is an important concept as Modern Portfolio Theory (MPT) is in part founded on it. Diversification in MPT terms can be defined as the goal of creating a portfolio of investment assets that has lower overall risk than assets in portfolios with the same expected return.

Taking a step back, Modern Portfolio Theory is a philosophy in finance that stresses the maximization of a portfolio's expected return for a given amount of risk, or equivalently minimize risk for a given level of expected return.

Global diversification in terms of the MPT has historically meant minimizing geopolitical risk in a portfolio by investing in a wide range of countries as opposed to just one. That way, if a country in Asia (for example) experiences a downturn (China?), an investor has less exposure to concentrated risk.

While such a theory may have been more applicable in the past, the world economy is now considerably more interdependent than it was even 15 years ago. Much of this new reality is due to increased speeds in both communication (internet) and transport (flight).

A recent episode of Market Measures examined the correlations between regionally-focused international securities and the conclusions of this analysis highlight some very interesting findings with respect to "international diversification."

Looking at the one-year chart of these four securities reveals a highly correlated pattern in their respective price movement, as depicted below:

Examining the price movement of these four securities using data as far back as 2004 adds another dimension to the analysis. During periods that include large swings in global markets, emerging markets have moved to a more extreme degree.

This phenomenon is shown below:

What we observe from the above information is that the increased interdependence of world economies has without question translated to equity markets.

From the data, the tastytrade research team extrapolated that the vast majority of the time that the S&P 5000 was up, so too were the other three indexes included in this study.

The bullet points below highlight the percentage of months that a particular index was up when the S&P 500 was up in a given month:

S&P/TSX Composite: 80%

MSCI Developed Markets: 86%

MSCI Emerging Markets: 74%

The above data further reinforces the finding that over the last ten years, global markets have moved together the vast majority of the time.

If you aren't convinced yet, a review of the next slide might push you over the edge.

The next chart depicts the correlations between many of the larger country-specific ETFs. Given that perfect correlation is 1.0, you can see that many of these relationships measure in well above .50, and in fact closer to .75:

While there are a myriad of takeaways that can be gleaned from this research, one of the most relevant appears to be the fact that "international diversification" may be less effective at minimizing risk than most would probably estimate.

In practice, international diversification seems to only add more of the same type of risk to a portfolio, as opposed to dampening the volatility of returns through the inclusion of negatively or non-correlated investments.

An important conclusion from this study is therefore that investors might be better served accessing "diversification" in their portfolio through less correlated securities instead of looking for diversification via global markets that appear to move mostly in unison.

The episode focusing on global diversification ends with Tom and Tony discussing some other products that traders can use to more effectively diversify their portfolios.

Bonds have historically offered a hedge for stocks, but with interest rates so low, this has become difficult.

We might consider looking for diversification closer to home by identifying securities that have low correlation.

As liquidity in foreign products can also be problematic, the strategy of using other products to achieve diversification may yield other benefits, too.

Please don't hesitate to contact us at support@tastytrade.com with any questions or comments.

Thank you for being a part of the tastytrade community!

Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.

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